Saving more over factor tilting, REITs, etc.
Saving more over factor tilting, REITs, etc.
I succeeded in recent weeks in driving myself crazy trying to determine whether or not adding additional exposure to REITs or small-cap value in my portfolio (which is generally a Three Fund approach, though having a 401k at work that leaves a lot left to be desired in terms of fees complicates that slightly) made sense. I read much of what everyone on this forum had to say (thank you to all of you), as well as various pieces on blogs and in some books. What I came up with that works the best for me - and I cannot emphasize the "for me" enough - increasing how much I can invest each month trumps tilting towards strategies, factors or asset classes.
It is possible that REITs could outperform the broad equity markets at, say, 2% per year for the next 30 years (expected retirement age). It is possible small-cap value could as well. But unless I tilt heavily into those sectors/strategies, the impact to my total portfolio would be 10-30 basis points of additional performance as a result of this hypothetical outperformance - and that ignores the likelihood that a persistent 2% outperformance would be dragged back to earth by investors piling into such a strategy (which some have argued is the case with value strategies in past years) or through simple regression to the mean (cue Taylor Larimore linking to the Tell Tale Chart).
I expect fully that capturing the returns of the broad domestic and international markets through their respective index funds will reward me enough over the next thirty years for the risk I am taking in investing in them during that time and put me in a position to meet my financial goals. I don't expect that I need additional return beyond what I expect from these indexes (approximately 7% in aggregate, in line with Jack Bogle's forecast).
When I began thinking about REITs or Small-Cap Value in an attempt to "juice returns," what I was really saying to myself is that I have a desire to end up with more wealth at the end of the road. Instead of all the frustrations of weighing whether or not additional allocations to this or that strategy/sector (and believe me, this was multiple hours of my day for the past two weeks), it dawned on me that if I could find an additional $50 per month to invest, that would represent an additional 6-7% of dollars invested per month. Over 30 years of retirement savings, that will add up tremendously - and likely (but not guaranteed) to put me in a better position had I invested a little less in a strategy that deviated from the Three Fund approach by tilting to SCV or REITS, etc.
Please understand that I am not saying the way to increase a portfolio's percentage returns is to increase the amount saved. I am saying that, for me, the path to being more comfortable with my financial plan (which includes staying the course and not trying to add a few points of performance by deviating) means slightly increasing the amount saved.
I also understand if many of you have gotten to this understanding way sooner than I have. However, I have seen time and again on this forum people asking about various factor tilts or strategies, etc., and while we seem to spend a good bit of time arguing on the merits, data, expected performance and future forecasts of those ideas, I rarely see it mentioned (forgive me those of you who have) that one solution to help the original poster be more comfortable with their investments is to simply save just a little bit more. That is the solution that is the most apparent to me.
As Bogle said, "Simplicity is the master key to financial success."
It is possible that REITs could outperform the broad equity markets at, say, 2% per year for the next 30 years (expected retirement age). It is possible small-cap value could as well. But unless I tilt heavily into those sectors/strategies, the impact to my total portfolio would be 10-30 basis points of additional performance as a result of this hypothetical outperformance - and that ignores the likelihood that a persistent 2% outperformance would be dragged back to earth by investors piling into such a strategy (which some have argued is the case with value strategies in past years) or through simple regression to the mean (cue Taylor Larimore linking to the Tell Tale Chart).
I expect fully that capturing the returns of the broad domestic and international markets through their respective index funds will reward me enough over the next thirty years for the risk I am taking in investing in them during that time and put me in a position to meet my financial goals. I don't expect that I need additional return beyond what I expect from these indexes (approximately 7% in aggregate, in line with Jack Bogle's forecast).
When I began thinking about REITs or Small-Cap Value in an attempt to "juice returns," what I was really saying to myself is that I have a desire to end up with more wealth at the end of the road. Instead of all the frustrations of weighing whether or not additional allocations to this or that strategy/sector (and believe me, this was multiple hours of my day for the past two weeks), it dawned on me that if I could find an additional $50 per month to invest, that would represent an additional 6-7% of dollars invested per month. Over 30 years of retirement savings, that will add up tremendously - and likely (but not guaranteed) to put me in a better position had I invested a little less in a strategy that deviated from the Three Fund approach by tilting to SCV or REITS, etc.
Please understand that I am not saying the way to increase a portfolio's percentage returns is to increase the amount saved. I am saying that, for me, the path to being more comfortable with my financial plan (which includes staying the course and not trying to add a few points of performance by deviating) means slightly increasing the amount saved.
I also understand if many of you have gotten to this understanding way sooner than I have. However, I have seen time and again on this forum people asking about various factor tilts or strategies, etc., and while we seem to spend a good bit of time arguing on the merits, data, expected performance and future forecasts of those ideas, I rarely see it mentioned (forgive me those of you who have) that one solution to help the original poster be more comfortable with their investments is to simply save just a little bit more. That is the solution that is the most apparent to me.
As Bogle said, "Simplicity is the master key to financial success."
In theory, there's no difference between theory and practice. In practice, there is. -Yogi Berra
Re: Saving more over factor tilting, REITs, etc.
To me, tilts and factors are like the exotica of any hobby. Say you occasionally like to fly model airplanes, and are OK at building them and pretty good at flying them. Then you join a model airplane club, and you find everyone in the club obsessing over carbon fiber wing flaps versus engineered plastic one week, or the kind of enamel used to coat the fuselage another week. You could be forgiven for scratching your head and wondering if it really makes a significant difference. Just go out and enjoy flying your plane. It's OK to not care about these things!
Savings rate, keeping costs down, staying the course....that's the most important stuff.
Savings rate, keeping costs down, staying the course....that's the most important stuff.
We don't see things as they are, we see things as we are.
Re: Saving more over factor tilting, REITs, etc.
An excellent point. We spend a lot of time arguing over things that matter very little, in particular whether or not to tilt and how often to rebalance. The things that matter are keeping expenses low, your savings rate, and your overall asset allocation.
What is that phrase? The narcissism of small differences?
What is that phrase? The narcissism of small differences?
Re: Saving more over factor tilting, REITs, etc.
I think that some passive investors like to overcomplicate things. The fact of the matter is that a long-only portfolio can capture only half of the value and size premiums and those premiums have been shrinking. Also the same people seem to ignore common sense investing principles. Take a look at the portfolio holdings of the Vanguard Small Cap Value Fund. You will always find a huge slide of financial sector exposure. It is pretty undiversified compared to the S&P 500 or Total Stock Market. Finally valuations matter a lot. REIT valuations are not cheap at all. You are getting maybe a 4% yield and a big chunk of the REIT sector (malls and strip centers) is being Amazoned. If you look at the safer sectors of REITs like apartments the yields are a joke 3% or below. REITs are expensive and will generate mediocre returns till valuations are corrected. People get all hung up in constructing an elegant, complex, all-weather portfolio and don't pay attention to first principles.
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Re: Saving more over factor tilting, REITs, etc.
We do expend far too much energy (and religiosity) on things that have relatively little material impact ..
However, the way I'd view returns and diversification is like this:
a) If you want higher returns, the simplest and most effective route is always to use leverage, up your asset allocation, or (as you say) save more .. If you can invest twice as much, you'll return twice as much .. This is a fairly safe bet;
b) However, there's always a chance your overweight asset class simply won't perform adequately over your investing horizon - and an outside chance it will lose you money ... So diversification is about having your eggs in more than one basket
If the equity risk premium goes on holiday for the next 30 years, it may still show up in small-value stocks (they expose you to a very different part of the market, and they do offer certain protections in things like market bubbles .. PS: don't go for the Vanguard Small-Value fund, I don't believe it captures the value premium) .. Or it may show up in real estate, and I'd add private equity .. But to get a real material impact, you do need fairly substantial allocations to tilts and alternatives
However, the way I'd view returns and diversification is like this:
a) If you want higher returns, the simplest and most effective route is always to use leverage, up your asset allocation, or (as you say) save more .. If you can invest twice as much, you'll return twice as much .. This is a fairly safe bet;
b) However, there's always a chance your overweight asset class simply won't perform adequately over your investing horizon - and an outside chance it will lose you money ... So diversification is about having your eggs in more than one basket
If the equity risk premium goes on holiday for the next 30 years, it may still show up in small-value stocks (they expose you to a very different part of the market, and they do offer certain protections in things like market bubbles .. PS: don't go for the Vanguard Small-Value fund, I don't believe it captures the value premium) .. Or it may show up in real estate, and I'd add private equity .. But to get a real material impact, you do need fairly substantial allocations to tilts and alternatives
"Economics is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions." - John Maynard Keynes
Re: Saving more over factor tilting, REITs, etc.
First to state the obvious, risk and return are linked. Second, I am a fan of REITs. I think the 3rd asset class that should be added after bonds and domestic equity should be REITs, not international equity. With that being said....
So you could increase your savings rate or move more of your AA into REITs. Both lower your risk. Or you could do both which should lower your risk even more.
This also is true for small caps but to a lesser expense. Even if the asset class is more efficient, the correlation with large caps is fairly high reducing the effect of diversification. (I personally don’t believe that small caps are now more efficient than large caps anymore, but that is a different story)
I think you are missing the argument for REITs – you don’t “juice” the returns by adding them. Historically, REITs’ risk and returns have been in-between equities and bond and have had low correlations to both. The low correlation is the crucial part. My future expectations are the same. By adding REITs one gets a more efficient portfolio, not a higher return. So by adding 10 to 15% REITs to a portfolio one gets the same expected return with lower risk.kdsunday wrote:It is possible that REITs could outperform the broad equity markets at, say, 2% per year for the next 30 years (expected retirement age).
You may think this is a related story but it is not. This is an independent story. If your goals are fixed and you increase your contributions, the required return falls. If the required return falls you can shift your portfolio to a more conservative stance.kdsunday wrote:Please understand that I am not saying the way to increase a portfolio's percentage returns is to increase the amount saved. I am saying that, for me, the path to being more comfortable with my financial plan (which includes staying the course and not trying to add a few points of performance by deviating) means slightly increasing the amount saved.
So you could increase your savings rate or move more of your AA into REITs. Both lower your risk. Or you could do both which should lower your risk even more.
This also is true for small caps but to a lesser expense. Even if the asset class is more efficient, the correlation with large caps is fairly high reducing the effect of diversification. (I personally don’t believe that small caps are now more efficient than large caps anymore, but that is a different story)
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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Re: Saving more over factor tilting, REITs, etc.
First, why is it black or white--why could you not do some of the things mentioned, not just one.
Second the expected returns for REITs is actually LESS than that of the market, let alone SV. The way you forecast REIT returns is to take the dividend and SUBTRACT 2%, about the rate of real growth in REIT earnings, versus say +2% for US stocks
and third, I investing is about putting odds in your favor, doing what is MOST LIKELY and diversifying risks because the unlikely happens a lot. TSM gives you exposure only to beta, not the other factors and causes you to have to hold more equity risk than if you tilt (because of the higher EXPECTED returns). And that means more left tail risk
Larry
Second the expected returns for REITs is actually LESS than that of the market, let alone SV. The way you forecast REIT returns is to take the dividend and SUBTRACT 2%, about the rate of real growth in REIT earnings, versus say +2% for US stocks
and third, I investing is about putting odds in your favor, doing what is MOST LIKELY and diversifying risks because the unlikely happens a lot. TSM gives you exposure only to beta, not the other factors and causes you to have to hold more equity risk than if you tilt (because of the higher EXPECTED returns). And that means more left tail risk
Larry
Re: Saving more over factor tilting, REITs, etc.
To the OP, it's not an either/or proposition. But yes, savings rate is definitely more important, especially earlier on.
Which data set are you looking at, and over which years? For 1972-2015 I'm seeing slightly higher returns for REITs along with negligibly higher risk, compared to the broad stock market, primarily from NAREIT data. And for what it's worth, Vanguard's 10-year forecast has REITs at lower expected returns than the overall stock market, but that's from a starting point of lower relative yields than typical. That comes with slightly higher simulated volatility, not lower.alex_686 wrote:Historically, REITs’ risk and returns have been in-between equities and bond and have had low correlations to both. The low correlation is the crucial part. My future expectations are the same. By adding REITs one gets a more efficient portfolio, not a higher return. So by adding 10 to 15% REITs to a portfolio one gets the same expected return with lower risk.
Re: Saving more over factor tilting, REITs, etc.
Don't forget that they could under-perform the broad equity markets as well. People making these "tilts" believe the odds are in their favor, people holding opposing positions probably believe they're position is more favorable... I'm sure as decades go by you'll be able to pick specific time periods that show both sides had their good times and bad.kdsunday wrote:... It is possible that REITs could outperform the broad equity markets at, say, 2% per year for the next 30 years (expected retirement age). It is possible small-cap value could as well. ...
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
Re: Saving more over factor tilting, REITs, etc.
I am taking a look at your data and I am seeing what you are seeing. And it doesn't feel right. I am misremembering studies I read years ago. Secular changes? Some quirk in the data? Sigh. I am not willing to conceded just yet but it is back to the books for me. Point to you for now.lack_ey wrote:Which data set are you looking at, and over which years? For 1972-2015 I'm seeing slightly higher returns for REITs along with negligibly higher risk, compared to the broad stock market, primarily from NAREIT data. And for what it's worth, Vanguard's 10-year forecast has REITs at lower expected returns than the overall stock market, but that's from a starting point of lower relative yields than typical. That comes with slightly higher simulated volatility, not lower.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.